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International Finance Practice Questions

1. The following are balance of payments (BOP) statistics for the United States.
2002 ($000,000)
Goods: exports
Goods: imports
Services: credit
Services: debit
Income: credit
Income: debit
Current transfers: credit
Current transfers: debit
Capital Account: credit
Capital Account: debit
Direct investment abroad
Direct investment in the
USA
Portfolio investment
assets
Portfolio investment
liabilities
Other investment assets
Other investment
liabilities
Net Errors and
Omissions
Reserves and Related
Items

685
1165
289
227
256
260
12
70
1
2
138
40
-16
421
53
246
-47
-4

i. What is the balance of trade?


ii. What is the current account balance?
iii. What is the financial account balance?
iv. Show that the BOP is balanced.
v. Give one example of a transaction that would be recorded under each of the
following:
Income: credit
Capital account: debit
Portfolio investment: liabilities
v. Discuss how a five-year history of a countrys BOP can assist you as the manager
of an MNC or of an international mutual fund in making decisions related to your
managerial functions.

2. You recall that a month ago the U.S. dollar/yen spot exchange rate was
bid $0.008600/ and ask $0.008610/. Today you went to the bank and saw
the following rates being advertised:
Spot

Bid ($/)
0.008805

Ask ($/)
0.008815

30-day forward
60-day forward

0.009025
0.009225

0.009040
0.009275

What is the percentage appreciation/depreciation of the dollar


(2.33% dep) and the yen (2.38% appr), respectively, over the last
month? (Use only the Ask quotes for this computation.)
ii.
What is the annualized 30-day forward premium/discount on the
yen (30.63% prem)? (Use only the Ask quotes for this
computation.)
iii.
What does the forward premium or discount computed in ii. mean?
iv.
What is the percentage bid-ask spread on the 60-day forward?
(0.539%)
Bid and ask quotes on currencies are here: http://www.reuters.com/.
Choose Markets and then Currencies.
i.

A forward option-dated transaction is a variation on a forward


transaction that is also called a window contract and has a variable
delivery date.
3. Today you went to the bank and saw the following quotes:
Bid ($/)
Ask ($/)
Spot
0.8695
0.8698
30-day forward
0.8699
0.8704
60-day forward
0.8707
0.8717
You recall that a month ago the spot exchange rate was bid $0.8590/ and
ask $0.8595/.
v.
What is the percentage appreciation/depreciation of the dollar
(1.184% dep) and the euro (1.198% appr) over the last month?
(Use only the Ask quotes for this computation.)
vi.
What is the annualized 30-day forward premium/discount on the
dollar (0.827% disc)? (Use only the Ask quotes for this
computation.)
vii. What is the percentage bid-ask spread on the 60-day forward?
(0.1147%)
viii. Suppose the bank had a bid of 1.15125/$ and an ask of 1.15105.
How would you interpret this quote? (Bank is transacting in the
numerator currency, the euro. Bid is $(1/1.15125)/ or $0.8686/
and ask is $0.8688/)
4. Today you went to the bank and saw the following quotes:
Spot
30-day forward

Bid ($/)
1.4905
1.4975

Ask ($/)
1.4925
1.4995

60-day forward

1.5125

1.5155

You recall that a month ago the spot exchange rate was bid $1.4765/ and
ask $1.4775/.
ix.
What is the percentage appreciation/depreciation of the dollar
(1.0047% dep) and the pound (1.0152% appr) over the last month?
(Use only the Ask quotes for this computation.)
x.
What is the annualized 30-day forward premium/discount on the
dollar (5.6020% disc)? (Use only the Ask quotes for this
computation.)
xi.
What is the percentage bid-ask spread on the 60-day forward?
(0.198%)
xii. Interpret the forward premium or discount computed in ii.
I have a general Question regarding depreciation and appreciation of a
currency. For example in problem 5 Chapter 18 in the book the spot rate is
ringgit3.8000/$ and the ringgit is expected to appreciate by 2%. How do I
calculate the expected exchange rate?
If you MULTIPLY by (1 + expected change) then you are computing either the
appreciation or depreciation of the FOREIGN currency the one under the slash
($).
If you DIVIDE by (1 + expected change) then you are computing either the
appreciation or depreciation of the HOME currency the one above the slash
(Ringgit).
Recall that to find the appreciation/depreciation of the HOME currency
(above slash), you can leave the exchange rate quote as is above and use the
following formula: (beginning ending)/ending.
So this gives: (3.8 ending)/ending = 0.02 (3.8 ending) = ending 0.02 3.8
= ending + ending 0.02 3.8 = ending(1 + 0.02) ending = 3.8/(1 + 0.02)
Note that if the Ringgit was expected to depreciate you would still follow the same
procedure, but set the 0.02 as -0.02, so you would get ending = 3.8/(1 - 0.02).

Recall that to find the appreciation/depreciation of the FOREIGN currency (under


slash), you can leave the exchange rate quote as is and use the following formula:
(ending beginning)/ beginning.
So if the $ was expected to appreciate by 5% this would be: (ending 3.8)/3.8 =
0.05 (ending 3.8) = 3.80.05 ending = 3.8 + 3.80.05 ending = 3.8(1
+ 0.05)

Note that if the $ was expected to depreciate you would still follow the same
procedure, but set the 0.05 as -0.05, so you would get ending = 3.8(1 - 0.05).

5. On your visit to the bank you also noticed the following rates:
0.6512/$
NOK8.2033/
NOK5.4543/$
i. Is there an arbitrage opportunity? If so, demonstrate clearly how you
can take advantage of it.
By writing the quotes so that each numerator currency cancels out with
itself in the denominator of the three quotes, we should get a product of 1.
There is arbitrage if:
0.6512/$ NOK8.2033/ $0.1833/NOK 1.
NB: [$(1/5.4543)/ NOK = $0.1833/NOK]
The product is equal to 0.9794, which is < 1, indicting there is an arbitrage
opportunity.
Because the product of the exchange rates is less than 1, all three exchange
rates are expected to increase so that their product becomes 1. If the
rates are expected to increase it means the numerator currency in each
quote is expected to depreciate and the denominator currency is expected
to appreciate. You should but the currency expected to appreciate by
selling the one expected to depreciate.
Assuming you are a U.S. resident:
Sell $1m to buy $1mNOK5.4543/$ = NOK5,454,300
Sell NOK to buy NOK5,454,300/ NOK8.2033/ = 664,890.96
Sell to buy 664,890.96/0.6512/$ = $1,021,024.20
You have made a profit of $21,024.20 on $1m or 2.10242% return. This
could have been inferred from the fact that if you had 0.9794 increased to 1,
the return is (1-0.9794)/0.9794 = 2.10%.
NB: The above could also have been done using:
$1.5356/ 0.1219/NOK NOK5.4543/$ = 1.0210 > 1, indicating a 2.10%
profit.
ii. The bank also quoted the dollar against the euro as $0.9050/. What is
the cross rate between the euro and the Norwegian kroner (/NOK)?

(1/0.9050)/$ $(1/5.4543)/NOK = 0.2026/NOK


6. A local bank has the following quotes:
C$1.6525/$
C$2.4788/

0.6575/$

i. Is there an arbitrage opportunity? If so, demonstrate clearly how you


can take advantage of it.
$0.6051/C$
opportunity

C$2.4788/ 0.6575/$ = 0.9863. There is an arbitrage

[using $(1/1.6525)/C$ = $0.6051/C$

ii. The bank also quoted the yen against the dollar as 125/$. What is the
cross rate between the yen and the Canadian dollar (/C$)?
7. You are quoted the following exchange rates between the U.S. and
Canadian dollars and interest rates in each country:
Current spot:
C$1.4900/$
1-year forward rate:
C$1.5100/$
Canadian interest rate:
5.0%
U.S. interest rate:
7.5%
(Assume that you can borrow or lend at the quoted interest rates.)
i. Is there an opportunity for arbitrage? If so, demonstrate clearly how
you can take advantage of it.
8. You are quoted the following exchange rates between the yen and the
U.S. dollar and interest rates in the U.S. and Japan:
Current spot:
127/$
1-year forward rate:
125/$
Japanese 1-year interest rate:
1.5%
U.S. 1-year interest rate:
5.5%
(Assume that you can borrow or lend at the quoted interest rates.)
i. Is there a covered interest arbitrage opportunity? If so, demonstrate
clearly how you can take advantage of it.

F1h / f (1 i h )

. We can use the Yen as the home


S 0h / f (1 i f )
currency, given the quotes (it does not matter if you invert and make the $
the home currency). This leads to 0.9843 0.9621. The rest is almost like
There is an arbitrage profit if

the above. One side should rise and the other should fall for the two to
become equal. That is, ih is likely to rise and if fall (or the forward rate fall
and spot rate rise).
We could profit if we:
1. Borrow yen and convert to dollars at spot rate
2A. Invest dollars at US interest rate for a year
2B. Forward sell the dollars expected from the US investment (all or part
depending on ones residency) at forward rate to get yen in one year
3. At end of year, deliver dollars to get yen, and repay yen loan to make a
profit

End-of-Chapter question 7.9 Covered Interest Arbitrage


Set the parity condition: Fkr/$/Skr/$ = (1 + ikr)/(1 + i$) (Note that the home currency in
this quote is the kr)
6.1980/6.1720 = (1.0125)/1.0075)
1.0042 1.0050
For parity to be restored, the two sides are expected to change so they become equal. One
way for this to happen is to have the LEFT side go up and/or the RIGHT side go down.
1.0042 = 1.0050
Suppose we focus on the RIGHT (interest rates) side only. If the right side is expected to go
down, then it means the Danish interest rate (ikr in the above formula) is expected to go
down or i$ is expected to go up.
The investment strategy here is to borrow now in the interest rate expected to go up later
and invest now in the interest rate which is expected to go down later. The intuition is, if
you must borrow, do it now and lock in the current lower rates and if you must invest, do it
now and lock in current high rates. In either case you are better off than waiting until
either rate changes.
[Note you cant exploit the IRP arbitrage without borrowing and investing and locking in
your gains in the forward currency market, so nothing comes out of your own pocket.]
This tells you to borrow $ now, as the rates are low now compared to the future, convert to
kr at the current spot rate, and invest the proceeds in kr interest rate securities.
1.

Convert $5m to kr
$5,000,000 x kr6.1720/$
= kr30,860,000
2.
Invest/deposit/lend kr at Danish interest rate for 90 days kr30,860,000 x
1.0125 = kr31,245, 750
3.
Simultaneously, sell kr forward to get $ in 90 days forward rate locked in
= kr6.1980/$

4.

In 90 days, use forward rate to convert kr to $ kr31, 245, 750 kr6.1980/$


= $5,041,263.31
5.
Profit earned
= $41,263.31
6.
Profit greater than if you invested directly in $ $5,000,000 x 1.0075
= $5,037,500
The IRP says that, investing in the dollar interest-earning security should give you the same
pay-off as investing in the foreign currency interest-earning security, because the higher
interest rate in the Denmark should lead to a depreciation of the Danish krone by just the
difference in interest rates. This would make the alternatives of $ or kr investments the
same.

Note that, as a shortcut to the decision which currency to borrow in


and which to lend/invest in:
a. look at the differences in the annual interest rates, [home rate minus foreign rate]
5 3 = 2% [annualized]
b. note that the currency with the higher interest rate [kr] is expected to have a forward
discount (or depreciate) over the life of the forward contract (or over the time that the
uncovered position is being held for) by the same percent difference in interest rate [2%
annualized]
c. compute the annualized forward discount (or depreciation) of the currency with the
higher interest rate
you need to compute the forward discount of the home currency one above the slash
[(F$/kr - S$/kr )/ S$/kr ]x 360/n =
[(0.1613 0.1620)/0.1620]*360/90 = -0.01678 or -1.678%.
Or use this formula to compute forward discount for the currency above the slash [(Skr/$
- Fkr/$)/Fkr/$ ]x 360/90
=
[(6.1720 6.1980)/6.1980]*360/90 = -0.01678 or -1.678%.
d. if interest rate difference is greater than the forward discount, then invest/lend in the
securities denominated in the currency with the higher interest rate because you will gain
more from the higher interest rate than you will lose from the depreciation of that
currency, leading to a net gain above what you could earn from investing in your own
countrys securities.
Since 2% interest rate difference is greater than the 1.678% forward discount, then
investing in kr securities will give you 2 percentage points more in interest (compared to
the 3% from investing in same securities in the U.S.) and that will not be offset by the 1.678
percentage points that you will lose because you have to convert from the weaker kr to the
$ in 90 days.

9. A speculator borrowed $1,000,000 for one year at an annual rate of 4.00% to


engage in uncovered interest arbitrage. The proceeds are invested in Mexican
money market securities at an annual rate of 9.00%. The spot rate at the time of
the loan was P10.1525/$. If a year later the spot rate is P11.3230/$, what is his
profit/loss?

10. Suppose that the current spot rate between the Mexican peso and the
U.S. dollar is MP10/$. Over the next year the rate of inflation in Mexico is
expected to be 12% and in the U.S. it is expected to be 3%.
i.

Given the difference in expected inflation rates, what PPP


exchange rate (MP/$) would you expect one year from today?

ii.

Suppose a year from now the inflation estimates turn out to be


accurate but the actual spot rate is MP12/$. Has the Mexican peso
experienced a real appreciation or depreciation, and how
much?

11. Suppose that the spot rate between the Jamaican dollar and the U.S.
dollar a year ago was J$45/$. Today the spot rate is J$40/$. During the year
the rate of inflation in Jamaica was 8% and in the U.S. it was 3%.
iii.

Given the difference in inflation rates, one year ago what exchange
rate (J$/$) would you have predicted for today?

Using the RPPP formula that links expected spot rate to inflation
differential, the expected real or PPP exchange rate at time t (in this case t
= 1) is
S

h/ f
t

h/ f
0

(1 i h ) t
1.08
J $45 / $
J $47.1845 / $ .
f t
1.03
(1 i )

That is, if RPPP holds we should have an exchange rate of J$47.1845/$,


because with higher inflation rate in Jamaica the J$ should depreciate
against the US$. Note that this is different from the actual rate, which
J$40/$.
iv.

What was the percentage change in the real exchange rate


($/J$) during the year?

When the rate is expressed as home/foreign currency (h/f) the real


S1h / f (1 i f )
1.
appreciation/depreciation of the foreign currency is h / f
S0
(1 i h )
To find the appreciation/depreciation of the J$, we can use the above
formula by making the J$ the foreign currency in the quote (i.e., $/J$). This
we do by inverting the quotes to get S 0 = $0.0222/J$ and S1 = $0.0250/J$.
Plugging into the formula, we get

0.0250 (1.08)

1
0.0222 (1.03)

= 0.1808 or 18.08%. This is a real appreciation of the Jamaican dollar


against the U.S. dollar. Note how different this is from the expected
depreciation. This implies that the J$ is overvalued, making Jamaican
exports not competitive in the U.S.
You should also note that this is different from the nominal appreciation of
the J$. When the rate is written as $/J$ the appreciation/depreciation of the
S1$ / J $ S 0$ / J $
J$ is:
.
S 0$ / J $
This gives {(0.025 - 0.0222)/0.0222} = 12.61% nominal appreciation of the
J$.
12. Sony produces LED+ TVs and exports them to the United States. Over the last
year the exchange rate was 90/$ and Sony charged 74,250 per DVD player. The
forecast for the coming year is for Japanese inflation of 3% and U.S. inflation of 7%.
Suppose Sony wishes to pass-through only 85% of any exchange rate changes to
its U.S. customers, what would be the new dollar price of the DVD player?

13. You are asked to use the futures market to hedge an expected cash
obligation of (Australian dollars) A$150m due on December 17, 2001. The
current spot rate is $0.6500/A$. The size of the futures contract is
A$100,000 and the price of the futures contract that expires on December
17 is $0.6650/A$.
i.

Should you buy or sell the futures contracts and how many?

Buy. A$150,000,000/A$100,000 = 1500 contracts


ii.

What is your profit or loss if on December 17 the spot rate is


$0.6735/A$?
Profit A$150,000,000*[$0.6735/A$ - $0.6650/A$] = $1,275,000
14. To hedge your Australian dollar obligation you decided to consider the
use of options. Suppose you observed that the December delivery Call
option has a 0.35 cents premium, while the Put has a 1.55 cents premium.
Both have an exercise price of $0.6635/A$ and a contract size of A$50,000.
The current spot rate is $0.6500/A$.
i.

Should you buy or sell the Call or the Put in order to hedge?

Buy call. (Selling put could cause large losses)

ii.

What is your net profit or loss if on December 17 the spot rate is


$0.6735/A$?

Profit = A$150,000,000*($0.6735/A$
$975,000

[$0.6635/A$+$0.0035/A$]) =

15a. On October 15, you were asked to hedge an expected cash inflow of
$15m Canadian dollars to be received on December 17, the delivery date of
the December futures contract for Canadian dollars on the CME. The
current spot rate is $0.5756/C$ and the current Canadian dollar futures
price for December delivery is $0.5872/C$. The Canadian dollar futures
contract is for C$100,000.
iii.
Should you have bought or sold futures contracts, and how many,
in order to hedge?
iv.
What is your profit or loss on the futures contracts if on December
17 the spot rate is $0.6082?
15b. Suppose the initial and maintenance margins on the Canadian
dollar futures are $1,500 and $1,100 per contract, respectively. Assume
that after hedging the futures closed at $0.5778 on the first day and then at
$0.5915 on the following day. Show the changes to the margin account,
indicating if there was a margin call and how much was it. (This can be
done using only one contract.)
16. A. 1. i. You will borrow $25m in 3 months time for a term of 6 months. The
loan rate will be LIBOR6+250 basis points. LIBOR6 is currently 2.5%. You enter
into a forward rate agreement (FRA) at a forward rate of 2.5%. If in three months
LIBOR6 is 1.5%, clearly show your net position from combining the FRA with the
loan.
ii. From part i, suppose the 6-month Eurodollar interest rate futures at the time
was 97.30. Should you buy or sell futures contracts to hedge? Clearly show your
net position from combining the Eurodollar futures and the loan.

B.i. You will borrow $10m in 3 months time for a term of 3 months. The
loan rate will be LIBOR3+150 basis points. LIBOR3 is currently 3.5%. You
enter into a forward rate agreement (FRA) at a forward rate of 3.5%. If in
three months LIBOR3 is 5.25%, explain fully how a FRA helped you.
Your concern is that LIBOR will increase at the time you lock in the rate in
three months time, resulting in a higher interest payment on the loan. So
you want to buy the FRA so that if LIBOR increases you get rewarded with a
cash inflow to use to partly offset the higher interest payment on the loan.
If LIBOR3 settles at 5.25% in three months your loan rate with the bank is
5.25 + 1.50 = 6.75%. For a 3-month loan the interest payment is:
$10,000,000*0.0675*(90/360) = $168,750.

10

By choosing a forward rate of 3.5% you are trying to obtain an effective loan
rate of 3.5 + 1.5 = 5.0%. If LIBOR settles at more than 3.5% when you are
ready to take the loan you will obtain a payoff from the FRA equal to:
FRA payoff = $10,000,000*[0.0525 0.035]*(90/360)
1+ (0.0525*(90/360))
= $43,183.
This is the PV today of the payoff from the FRA which occurs in three
months time at the date that you get the loan. Its value in the three
months time when you get the loan is $43,750.
Hence, considering the inflows from the FRA in three months, your net
interest payment is $125,000. This is what you would have paid if you got
the loan at 3.5% + 1.5%, the rates you lock in with the FRA.
ii. From part i, suppose the 3-month Eurodollar interest rate futures at
the time were 96.30. Should you buy or sell futures contracts to hedge?
Explain how the Eurodollar futures helped you.
Since you fear an increase in interest rates are going to increase your loan
cost, you need to hedge in the interest rate futures market in such a way
that if interest rates do increase in the future you get an inflow of cash
(profit) so that you can use it to partly offset the higher rate you would pay
on the loan.
So, you need to SELL futures contracts today. If interest rates increase later
the contracts lose value and so you can buy them back cheaper and make a
profit.
The interest rate implied by the futures contract is 100 96.3 = 3.70%.
The price of $10,000,000 of contracts today is: $10,000,000 *[1 - .
037*(90/360)] = $9,907,500.
At expiration the spot interest rate is the same as the futures interest rate.
If this rises to 5.25% then the value of the futures contract will fall (price
and interest rates move inversely for fixed income securities).
The new price is: $10,000,000 *[1 - .0525*(90/360)] = $9,868,750. You will
buy the contract at this price and by doing so discharge the legal obligation
imposed on you when you sold the futures. Your profit in the futures market
(not considering brokers commission, initial margin, and margin call) is
$9,907,500 - $9,868,750 = $38, 750. This will be used to partially offset the
higher loan cost.

11

17. i. CanTech Inc. entered into a two-year cross-currency interest rate


swap to receive U.S. dollars and pay euros. The notional principal is $16m.
This is a nonamortizing swap with payments made once per year at year
end. The current spot rate is $1.6000/ and the swap rates are U.S. dollar
2.85% and euro 4.00%. What are the dollar and euro cash flows from the
swap over the life of the swap?
ii. Suppose CanTech decides to unwind the swap after one year when the
spot rate is $1.5825/ and the one-year swap rates are U.S. dollar 3.05%
and euro 4.05%. Compute the NPV of the swap and indicate who receives
payment.
18. CanTech Inc. entered into a three-year cross-currency interest rate
swap to receive U.S. dollars and pay pounds. The notional principal is
$45m. This is a nonamortizing swap with payments made once per year at
year end. The current spot rate is $1.5000/ and the swap rates are U.S.
dollar 1.85% and pound 2.05%.
i. What are the dollar and pound cash flows from the swap over the life of
the swap?
ii. CanTech decides to unwind the swap after one year when the spot rate is
$1.4850/ and the two-year swap rates are: U.S. dollar - 1.95% and British
pound - 2.30%.
Compute the NPV of the swap and indicate who receives payment.
At the end of one year there are two remaining payments in the currency
swap and these have to be used in computing the PVs:
[$832,500/(1+0.0195) + $45,832,500/(1+0.0195) 2]
[615,000*($1.4850/)/(1+0.0230) +
30,615,000*($1.4850/)/(1+0.0230)2]
19. i. International Freights, Inc. can directly access floating rate funds at
LIBOR + 2% and fixed-rate funds at 7%. It has a preference for a fixed-rate
loan. Zylan Foods, which prefers a floating-rate loan, has access to
fixed-rate funds at 5% and floating-rate funds at LIBOR + .75%. A swap
bank can arrange an interest rate swap for 25 basis points on a notional
principal of $10 million and International Freights and Zylan Foods would
split any remaining cost savings equally. Explain clearly if they can benefit
from a swap, the loans each should take, the payments each will make, and
net loan cost for each. (10 points)
12

20. i. Company X, a low-rated firm, desires a fixed-rate, long-term loan. X


presently has access to floating interest rate funds at LIBOR+1.25%. Its
direct borrowing cost is 11% in the fixed-rate bond market. In contrast,
company Y, which prefers a floating-rate loan, has access to fixed-rate funds
in the Eurodollar bond market at 9% and floating-rate funds at
LIBOR+0.25%. A swap bank can arrange a swap for 10 basis points on a
notional principal of $50 million and X and Y would split any remaining cost
savings equally. Explain if they can benefit from an interest rate swap, the
loans each should take, the payments each will make, and net loan cost for
each.
Y has absolute advantage in both the fixed and floating rate markets, but
has comparative advantage in the fixed rate market because it can borrow
at 2 percentage points lower than X (11 9), compared to only 1 percentage
point (LIBOR + 1.25 (LIBOR + 0.25)). Hence there is an opportunity to
benefit from a swap.
The amount to be shared is 1 percentage point [(11 9) - (LIBOR + 1.25
(LIBOR + 0.25))].
So, the 100 basis points will be split as follows: 10 points for the swap bank,
45 points for X, and 45 points for Y.
Y, with the comparative advantage in the fixed rate market will borrow at
the fixed rate of 9% even though it prefers floating rate.
<<<< This means that Y will have an obligation to pay 9% to the lender. It
swaps to have that paid by someone else.
X, has a comparative advantage in the floating rate market and will borrow
at the floating rate of LIBOR + 1.25%.
<<<< This means that X will have an obligation to pay LIBOR + 1.25% to
the lender. It swaps to have that paid by someone else.
They will then swap the above loan payments. That is, they will receive the
above payments and end up paying the loan they prefer.
You should then get a net borrowing rate for X as 11 0.45 = 10.55.
<<< This is the best rate it could borrow on its own in the market it prefers
(fixed) minus the benefit from the swap.

13

You should then get a net borrowing rate for Y as LIBOR +0.25 0.45 =
LIBOR 0.20%.
<<< This is the best rate it could borrow on its own in the market it prefers
(floating) minus the benefit from the swap.
Follow the example done in class to draw the flows with the swap bank in
the middle.
21. The Land's Beginning Company Inc. (LBC), located in Seattle, imports extreme
condition outdoor wear and equipment from The Hudson Bay Company (HBC)
located in Canada. With the steady decline of the U.S dollar against the Canadian
dollar LBC is finding a continued relationship with HBC to be an increasingly
difficult proposition. In response to LBC's request, HBC has proposed the following
currency risk-sharing arrangement. First, set the current spot rate of
C$1.2000/$ as the base rate. As long as spot rate stays within 5% (up or down)
LBC will pay at the base rate. Any rate outside of the 5% range, HBC will share
equally with LBC the difference between the spot rate and the base rate.
i. Given the current spot rate is C$1.2000/$, what are the upper and lower limits
for trading to take place at C$1.2000?
ii. If LBC has a payable of C$100,000 due today and the current spot rate is
C$1.1250/$, how much does LBC owe in U.S. dollars?

22. Du Pont has entered into a currency risk sharing arrangement with
British Gas. Under the contract, Du Pont agrees to pay British Gas a base
price of $10 million for gas purchases, but the parties would share the
currency risk equally beyond a neutral zone, specified as a band of
exchange rates: $1.67/-1.73/. Within the neutral zone, Du Pont must pay
BG the pound equivalent of $10 million at the base rate of $1.70/.
Suppose the spot rate at the time of payment is $1.63/. How much will Du
Pont owe British Gas?
Amount owed in f.c. at base rate = ($10,000,000/($1.70/ )) = 5,882,352.94. This
amount to the party receiving the funds will not change if the rate is within the
zone when payment is due.
This could cost the payer between 5,882,352.94*$1.67/ = $9,823,529.41 and
5,882,352.94*$1.73/ = $10,176,470.59 within the zone.
Now that the spot rate is $1.63/, Du Pont alone would benefit from the

appreciation of the US$ if the risk-sharing arrangement was not in place.


With the risk-sharing arrangement the gain is shared between both parties.
The gain to Du Pont, which they will have to share, is the difference
between the bottom of the range and the current low spot rate: $1.67/ -

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$1.63/ = $0.04/. The new risk-sharing rate = (1.70-(0.5*(1.67-1.63))) =


$1.68/. That is, that which would have to be paid if the exchange rates remain
relatively stable and kept within the range less half the gain.
The f.c. amount owed and to be paid to BG under the risk sharing arrangement is:
$10,000,000/(1.70-(0.5*(1.67-1.63))) = 5,952,380.95. This will cost, at the
current spot rate, 5,952,380.95*$1.63/ = $9,702,380.95

COMPARISON OF PQ #22 AND CHP 12 #5


NB: Student question highlighted; my answers in red or blue and not
highlighted.
Could you please clarify the effective rate calculation in # 22 of the Practice
Questions?
Effective rate = base rate + 0.5*(current spot rate lower bound rate)
The new risk-sharing rate = (1.70 + (0.5*(1.63-1.67))) = $1.68/
Note that the above is mathematically equivalent to (1.70-(0.5*(1.67-1.63))),
the answer in PQ # 21 above, but it is presented like I did it in class. The
way I did it in class is preferred, even if the books test bank does it
differently.
But in class you said that if we have a base rate the calculation would be:
Effective Rate = Base Rate + 0.5(Spot Rate Base Rate)
However, PQ #22 is using:
Effective Rate = Base Rate + 0.5(Spot Rate Lower Bound Rate)
I understand the mathematical equivalence between both methods. What Im
confused with is the fact that in class you mentioned that if we were given a base
rate, we should use it instead of any upper or lower bound rate. Hence, shouldnt it
be:
Effective Rate = Base + [0.5*(Spot Base)]
Why does the formula that the PQ uses to solve #22 mixes the Base Rate and the
Lower Rate?
Effective Rate = Base + [0.5*(Spot Lower)]

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Which is the preferred method to solve the


question?
There is no preferred method. The method depends on the question asked
or, more specifically, on the information given about the contract.
In the PQs #22 it says:

the parties would share the currency risk equally beyond a neutral zone,
specified as a band of exchange rates: $1.67/-1.73/.
This implies using the upper or lower bound as appropriate to make the
adjustment to the base rate, just as you point out above that it does.
Note also for this contract that if the rate falls within the neutral zone, Du
Pont must pay BG using a fixed exchange rate (the base rate) of $1.70/.
Now look at chapter 12 # 5 and see what it says:
However, if the spot rate at the time of the shipment falls outside of this +/- 5%
range, Morris Garage will share equally the difference between the actual spot
rate and the base rate. This is what we did in class and is expressed in your first
formula above.
Note also that this contract says that if the spot rate falls in the +/ 5% range the
actual spot rate is used.
These are two different contracts. This is what I was saying in class that it
depends on the contract.
23. In December your firm had an obligation of CHF8 million due in June, around
the expiration date of the June futures and options contracts. You were asked to
hedge exchange rate risk and you gathered the following information.
DECEMBER
a. Spot exchange rate was (S0): $0.9000/CHF.
b. 180-day forward (F180) quotes for the Swiss francs: $0.9268 - 72/CHF.
c. Eurocurrency rates from a local bank
Term
6-month borrowing rate
6-month deposit rate

U.S. dollar
4.00% p.a.
3.90% p.a.

Swiss francs
1.05% p.a.
0.95% p.a.

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d. Futures price at market opening was $0.9105/CHF. Each contract is for


CHF125,000 and the roundturn commission was $12.50 per contract.
e. The strike price and premiums for options expiring in June were as follows:
Strike
Call
Put
Option strike and premium
9000
4.50
1.50
JUNE
f. At the option and futures expiration date in June the spot exchange rate was
$0.9600/CHF.
i. If you hedged using the futures market, did you buy or sell? What was your
overall position considering both the spot and futures market transactions in June?
ii. The futures broker had asked for an initial margin of $1,000 per contract and
requires a maintenance margin of $850. You recall that on the first day at the
close the futures settle price was $.9125/CHF. At the close on the second day, it
was $0.9005/CHF. Show the transactions and balances related to the margin
account, indicating if there was a margin call and the amount.
iii. If you hedged using the forward market, did you buy or sell Swiss francs, what
was your net cost?
iv. If you hedged using the options market, did you use calls or puts and what was
your net cost?
v. Demonstrate the money market hedge, stating the amount of domestic currency
you paid for the foreign currency obligation. What exchange rate did you lock in?
24. A U.S. firm exports today to a British company for 100,000. The current
exchange rate is $2.03/, the account is payable in three months, and the firm
chooses to avoid any hedging techniques designed to reduce or eliminate the risk
of changes in the exchange rate. If the exchange rate changes to $2.01/ on the
day of the payment, how is the firm affected?
25. Tampa Juices Inc. has just borrowed 1,000,000 to make improvements to an
Italian fruit plantation and processing plant. If the interest rate is 7.00% per year
and the euro depreciates against the dollar from $1.15/ at the time the loan was
made to $1.10/ at the end of the first year, what is the before-tax cost of capital
if the firm repays the entire loan plus interest (rounded)? (
2.35%)
26. Tampa Juices Inc., a U.S.-based firm, has just borrowed 1,000,000 to make
improvements to an Italian fruit plantation and processing plant. Suppose the
interest rate is 7.00% per year and the exchange rate changes from $1.15/ at the
time the loan was made to $1.20/ at the end of the first year.
i. What is the before-tax cost of capital if the firm repays the entire loan plus
interest? (11.65%)
ii. Tropical Fruits Inc. is in the 30% marginal tax bracket. What is the after-tax
cost of capital if the firm repays the entire loan plus interest? (8.16%)

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